Cours MA Private Equity
Cours MA Private Equity
Cours MA Private Equity
S9 GFC
ENCG Dakhla
2020-2021
• Background on M&As;
• Deal structuring;
• M&As valuation;
3
References
M&A:
• Bruner R. (2004) Applied Mergers and Acquisitions, Wiley.
• Gaughan, P. (2010) Mergers, acquisitions and corporate
restructurings, 5th edition, Hoboken, John Wiley & Sons.(*)
• Depamphilis, D. (2011) Mergers acquisitions and other
restructuring activities, 6th edition, Academic Press. (*)
• Sudarsanam S. (2010) Creating Value From Mergers And
Acquisitions, Prentice-Hall.
• Weston J.F. and Weaver S.C. (2001) Mergers and Acquisitions,
McGraw Hill.
Private Equity:
• Talmor, E. and Vasvari, F. (2011) International Private Equity,
John Wiley & Sons. (*)
* : eBook available
Background on M&As
Mergers and Acquisitions:
3 Types
A transaction where 2 firms agree to integrate their
Merger operations on a relatively co-equal basis;
•The words are often used interchangeably even though they mean
something very different.
– Horizontal:
• Involve firms operating in similar businesses (competitors)
– i.e. Chevron and Texaco; Exxon and Mobil
– Vertical:
• Occur in different stages of production operations (buyer-seller
relationship)
– i.e. Time Warner and AOL
– Conglomerate:
• Firms are in unrelated business activities (not competitors and
no buyer-seller relationship)
– i.e. Philip Morris acquired (General Foods 1985, Kraft 1988
and Nabisco 2000).
Legal Forms of Acquisitions
•Acquisition of Assets:
• It’s not necessary to own 100% to exert control over the target:
• Disadvantages:
•Diversification
Quick way to move into businesses when firm currently lacks
experience and depth in industry.
Example: CNET’s acquisition of mySimon.
– How much should the bidder “A” pay for the target “B”?
At least VB. In this case the bidder shareholders keep
most benefits from merger.
At most VAB – VA. Here benefits accrue to target
shareholders.
Why Do It?
Theories and Reasons (Cont.)
• There are 2 types of synergies: operating and financial.
– Operating synergies:
• Allow firms to increase their operating income and/or growth:
– Revenue enhancement: The combined firm may
generate greater revenues than two separate firms due
to:
• Marketing gains
• Strategic benefits (Talent, brands, business models,
relationships, reputation, ….)
• Market power
• Undervaluation:
Firms that are undervalued by the market can be targeted for
acquisition. However, acquirer should take into account the
premium!
• Earnings growth
Company A Company B
Present earnings $20,000,000 $5,000,000
Shares outstanding 5,000,000 2,000,000
Earnings per share $4.00 $2.50
Price per share $64.00 $30.00
Price / earnings ratio 16 12
Why Do It?
Theories and Reasons (Cont.)
Surviving Company A
• Surviving firm EPS will increase any time the P/E ratio “paid”
for a firm is less than the pre-merger P/E ratio of the firm
doing the acquiring. [Note: P/E ratio “paid” for Company B is
$35/$2.50 = 14 versus pre-merger P/E ratio of 16 for
Company A.]
Why Do It?
Theories and Reasons (Cont.)
Surviving Company A
• Surviving firm EPS will decrease any time the P/E ratio “paid” for a
firm is greater than the pre-merger P/E ratio of the firm doing the
acquiring. [Note: P/E ratio “paid” for Company B is $45/$2.50 =
18 versus pre-merger P/E ratio of 16 for Company A.]
Why Do It?
Theories and Reasons (Cont.)
– PER?
– Where did the cash come from?
– What will increased leverage do to required rate of return?
Why Do It?
Theories and Reasons (Cont.)
Without the
merger
Time in the Future (years)
•Integration Difficulties
Differing financial and control systems can make integration of
firms difficult.
Example: Intel’s acquisition of DEC’s semiconductor division.
•Inadequate Evaluation of Target
“Winners Curse” bid causes acquirer to overpay for firm.
Example: Marks and Spencer’s acquisition of Brooks Brothers.
•Large or Extraordinary Debt
Costly debt can create onerous burden on cash outflows.
Example: AgriBioTech’s acquisition of dozens of small seed firms.
Problems with M&As (Cont.)
Overcome Inadequate
entry barriers evaluation of target
Avoid excessive
competition Too large
History of M&As (Cont.)
Mergers have typically occurred in cyclical patterns: periods of
intense merger activity have been followed by intervening periods of
fewer mergers.
Period Events coinciding with beginning of wave Events coinciding with
end of wave
1890’s- 1903 Economic expansion; industrialisation processes; Stock market crash;
Wave introduction of new state legislations on incorporations; economic stagnation;
1 development of trading on NYSE; radical changes in beginning of First World
technology War
Wave 1910’s – 1929 Economic recovery after the market crash and the First Stock market crash;
2 World War; strengthen enforcement of antimonopoly beginning of Great
law Depression
Wave 1950’s – 1973 Economic recovery after the Second World War; Stock market crash; oil
3 tightening of anti-trust regime in 1950 crisis; economic
slowdown
1981 – 1989 Economic recovery after recession; changes in anti- Stock market crash
Wave trust policy; deregulation of fin. services sector; new
4 financial instruments and markets (e.g. junk bonds);
technological progress in electronics
Wave 1993 – 2001 Economic and financial markets boom; globalization Stock market crash;
5 processes; technological innovation, deregulation and 9/11 terrorist attack
privatisation
Wave 2003 - 2007 Economic recovery after the downturn in 2000–2001 Subprime crisis
6
History of M&As (Cont.)
Worldwide M&A environment
Global Announced M&A Activity — 1/1/1985 – 9/5/2006
3 500 45 000
Number of deals
Deal value
2 000 25 000
1 500 20 000
15 000
1 000
10 000
500
5 000
87
89
91
93
95
97
99
01
03
05
19
19
19
19
19
19
19
19
20
20
20
History of M&As (Cont.)
Target
ABNORMAL RETURN (%)
CUMULATIVE AVERAGE
0 Bidder
20.00% Bidder
Target 15.00%
CAR (%)
10.00%
EXXON
MOBIL
5.00%
0.00%
-5 -4 -3 -2 -1 0 1 2 3 4 5
-5.00%
Day relative to announcement day
Where M&A Pays and When it Strays
• Golden Parachute
– An extremely lucrative severance package that is guaranteed to
a firm’s senior management in the event that the firm is taken
over and the managers are let go.
– If a golden parachute exists, management will be more
likely to be receptive to a takeover, lessening the likelihood of
managerial entrenchment.
• White Squire
– A variant of the white knight defense, in which a large,
passive investor or firm agrees to purchase a substantial
block of shares in a target with special voting rights.
• “Pac-Man” Defense
– The target firm turns around and tries to acquire the other
company that has made the hostile takeover attempt.
• Leveraged Recapitalization
– With recapitalization, a company changes its capital structure
to make itself less attractive as a target.
– For example, companies might choose to issue debt and then
use the proceeds to pay a dividend or repurchase stock.
Deal Structuring
Deal Structuring
– Methods of payment
– Exchange ratio
– Control premium
– Contingent Payout: Earnout
– Accounting methods
– Due diligence
M&A Financing
• M&A may be paid for in 3 ways: cash; stocks; hybrids
(combination of cash and stocks).
• Cash offering
– Cash offering may be cash from existing
acquirer balances or from a debt issue.
• Securities offering
– Target shareholders receive shares of
common stock, preferred stock, or debt of
the acquirer.
– The exchange ratio determines the
number of securities received in exchange
for a share of target stock.
• Factors influencing method of
payment:
– Sharing of risk among the acquirer and
target shareholders.
– Signaling by the acquiring firm. Based on data from Mergerstat Review, 2006.
– Capital structure of the acquiring firm. FactSet Mergerstat, LLC (www.mergerstat.com).
– Size of the transaction (The method of
payment in the largest transactions is
predominately stock for stock)
M&A Financing (Cont.)
Target Bidder
Shareholders Shareholders
Target Bidder
Target Bidder
Shareholders Shareholders
Assets
Target Bidder
Cash +
Target Assets Assumption Bidder Assets
and Liabilities of Selected and Liabilities
Liabilities
Sale of Assets for Cash (Cont.)
Target Bidder
Shareholders Shareholders
Target Bidder
Target Bidder
Shareholders Shareholders
Cash
DISSOLUTION
Target Bidder
Target Bidder
Shareholders Shareholders
Cash
Bidder
Bidder Assets
and Liabilities
Target Assets
Selected Liabilities
Stock-for-Stock Merger
Target Bidder
Shareholders Shareholders
Target Bidder
Target Bidder
Shareholders Target shares Shareholders
become Bidder
shares
Bidder
Bidder Assets
and Liabilities
Target Assets
and Liabilities
The Exchange Ratio in a Stock for Stock
Exchange
• Exchange Ratio: The number of shares the target shareholders
receive from the acquiring firm in exchange for their current
shares.
Exchange Ratio = Value per Share of Target Firm (with control premium)
Value per Share of Bidding Firm
• If the exchange ratio is set too low, there will be transfer of wealth
from the target firm to the bidding firm’s stockholders.
Control Premium
Example
Example:
In the case of the acquisition premium will be calculated as follows:
• This is the minimum value that must be created in the deal to make
the acquirer’s shareholders as well off as they were before the deal.
Case Example:
• Some empirical studies (e.g. Kohers and Ang, 2000) report that
the returns to buyers are higher when the payment is structured
to be contingent on meeting future performance benchmarks.
Volume of deals involving Earnouts by year, and in comparison to all deals
Earnout deals % Payment due
to Earnout
Year Total value ($ Mil) % all deals Number % all deals
1985 4,47$ 0.4% 8 1.3% 51%
1986 2,081$ 0.9% 15 1.2% 26%
1987 1,697$ 0.9% 15 1.1% 44%
1988 1,795$ 0.7% 26 1.5% 54%
1989 2,775$ 0.9% 52 2.4% 24%
1990 1,438$ 0.8% 53 2.6% 21%
1991 2,254$ 1.8% 55 2.8% 30%
1992 1,273$ 1.1% 61 2.7% 40%
1993 4,332$ 2.5% 89 3.4% 21%
1994 1,990$ 0.7% 92 2.7% 88%
1995 7,150$ 1.8% 86 2.3% 27%
1996 8,832$ 1.5% 85 2.0% 19%
1997 11,712$ 1.7% 144 3.1% 29%
1998 9,845$ 0.8% 167 3.5% 28%
1999 13,562$ 0.9% 163 1.7% 21%
2000 26,028$ 1.6% 174 1.9% 23%
2001 15,645$ 2.2% 151 2.4% 27%
2002 8,089$ 2.1% 150 2.6% 29%
Source: SDC, M&A database
Contingent Payout: Earnout (Cont.)
Examlpe 1:
• Say an entrepreneur selling a business is asking $2,000,000 based
on projected earnings, but the buyer is willing to pay only
$1,000,000 based on historical performance.
• An Earnout provision structures the deal so that the entrepreneur
receives more than the buyer's offer only if the business achieves a
certain level of earnings. The exact numbers would depend upon the
business, but in this example a simplified provision might set the
purchase price at $1,000,000 plus 5% of gross sales over the
next three years.
• The Earnout thereby helps eliminate uncertainty for the buyer.
Contingent Payout: Earnout (Cont.)
Example 2:
Company X has posted an EBITDA of $4 million the last fiscal year.
The seller values the company at $20 million (a valuation multiple 5x
EBITDA). The M&A buyer believes the valuation is $18 million (a
valuation multiple of 4.5X EBITDA). The lower valuation is due to the
buyer’s concern that future EBITDA might be less than $4 million.
Therefore, the valuation gap between the seller and buyer is $2 million.
– Bridging the valuation gap: The most common reason for using
an Earnout is to bridge the gap between the buyer’s and the
seller’s evaluation of the intrinsic value of the target.
– The balance sheet of the merged firm is nothing more than the
two separate balance sheets added together.
Accounting Aspects (Cont.)
Example
Let’s illustrate this method by an actual case: Down Chemical / Union
Carbide merger (1999).
The following table presents the pro forma balance sheet taken from
the proxy to shareholders in the Down Chemical / Union Carbide
merger (figures are displayed in millions of $):
• …. Why?
– If the acquiring firm pays a premium over the target firm’s book
value (e.g. for intangible assets, such as a promising new
technology developed by the target), the difference is booked
against goodwill.
The Acquirer purchases the Target firm for $1,250 in cash on June 30,
2006.
Target Firm
Acquirer Pre- Target Firm (Fair Market
Merger (Book Value) Value)
Current assets 10 000 1 200 1 300
Long-term assets 6 000 800 900
Goodwill
Total Assets 16 000 2 000 2 200
Goodwill = Acquirer
Price paid – MV
Value preofmerger
Target+firm Equity
Target Firm (FMV) = Acquirer Post Merger
Transaction Assumptions
A acquires B
Each share of B is exchanged for $24 cash
Total transaction size is $200, which A raises by issuance of $100 in long-term debt and $100 in excess cash
Purchase Method of Accounting
Example 3 cont’d
• Purchase Method of Accounting. B/S Example:
Notes on B/S:
- a Since B is on LIFO, B’s B/S understates the value of B’s inventory
by $10
- b B’s fixed assets are worth 50% more as a result of long-term
inflation effects
- c Goodwill incurred by B in its own past acquisitions has no
identifiable value and therefore is eliminated
- d B’s outstanding fixed-rate debt is worth less today because of
general interest rate rises. It therefore must be revalued at a
discount
- e B’s deferred tax liabilities are increased by the tax effect on
timing differences arising from valuation adjustments, which creates
an additional deferred tax provision of $25 (at a 38% tax rate)
• Purchase Method of Accounting. B/S Example:
Notes on B/S: (cont.)
- f This is a balancing adjustment reflecting the net effect on the fair
value of B’s common equity
• Product
• Distribution
• Production
• Service
Due Diligence (Cont.)
– If the buyer offers too little, the target may resist and seek to
interest other bidders.
– If the price is too high, the premium may never be recovered
from post merger synergies
Valuation in M&A
VB
Combined entity:
VBT > +
VT
– If the bidder pays a premium < €20 million => It will share in the
value ↑.
– If the bidder pays a premium > €20 million => The value of the
bidder will ↓.
The Use of Stocks in M&A
• High % of M&A transactions beginning in 1992 has been stock
for stock transactions.
• Some hold the view that this does not represent real money. But
this is not valid!!!!
Example:
• Scenario 1: B exchanges 1 of its shares for 1 share of T.
• Since the combined firm is valued €100, T will receive 0.5 x €100
= €50
Ownership
Pre-merger Post-merger
• Scenario 2:
Ownership
Pre-merger Post-merger
• Scenario 3:
Ownership
Pre-merger Post-merger
B =50% T=50% B =36.36% T=63.64%
Valuation Methods
• Higher expected growth, low risk in the company’s sector and low
interest rates will all push multiples higher
Enterprise value
multiples (the value of
capital employed)
Indirect approach
=> EBITDA multiple;
Revenue multiple, FCF
multiple, …
There are two
major groups of
multiples
EV
EBITDA MULTIPLE
EBITDA
Multiples, Indirect Approach (Cont.)
Other multiples
• P/E ratio
• Price to Book ratio
• Price to Cash Flow ratio
• Ratios:
Market Capitalisation
P/CF =
Cash flow
112
Assuming that the average of the values from the different multiples is
most appropriate:
Comparables’ Estimated
Multiples Stock Value
Earnings $10 million × 30 $300 million
Cash flow $12 million × 25 $300 million
Book value of equity $50 million × 2 $100 million
Sales $100 million × 2.5 $250 million
Average = $237.5 million
Advantages
Disadvantages
– Sensitive to market mispricing
– Sensitive to estimate of the control premium, and historical
premiums may not be accurate to apply to subsequent mergers
– Does not consider specific changes that may be made in the target
post-merger
Comparable Transactions Approach
Collect
information on Calculate Estimate the
recent multiples for target Value
transactions of comparable based on
comparable companies multiples
companies
Comparable Transactions Approach (Cont.)
Example:
Suppose an analyst has gathered the following information on the
target company, the MNO Company:
Average of Multiples of
MNO Company Comparable Transactions
Earnings $10 million P/E of comparables 15 times
Cash flow $12 million P/CF of comparables 20 times
Book value of equity $50 million P/BV of comparables 5 times
Sales $100 million P/S of comparables 3 times
Comparables’
Transaction Estimated
Multiples Stock Value
Earnings $10 million × 15 $150 million
Cash flow $12 million × 20 $240 million
Book value of equity $50 million × 5 $250 million
Sales $100 million × 3 $300 million
Comparable Transactions Approach (Cont.)
• Advantages
– Does not require specific estimation of a takeover premium
– Based on recent market transactions, so information is current
and observed
– Reduces litigation risk
• Disadvantages
– Depends on takeover transactions being correct valuations
– There may not be sufficient transactions to observe the valuations
– Does not include value of changes to be made in target
122
FCFt
In theory… EV t
t 1(1 K c)
123
• The value of the firm is the sum of the present value of after-
tax cash flows over the explicit forecast period and the
terminal value at the end of the explicit forecast period.
PV of
n FCFt FCFt terminal
EV t
t
period
t 1(1 Kc) t n1(1 Kc)
Sum of initial
PV
125
• For free cash flows (that’s flows to all providers of capital), the
appropriate rate will be a blend of the required rates of return
on debt and equity, weighted by the proportion of those
sources of capital in the firm’s market value capital structure.
Cost of Capital
E D
WACC ke k d (1 T)
ED E D
1. Equity
2. Debt
132
The cost of equity capital, ke, is the discount rate that equates the
present value of all expected future dividends with the current
market price of the stock.
D1 D2 D
P0 = + +...+
(1+ke) (1+ke)
1 2 (1+ke)
Constant Growth Model
Ke = ( D1 / P0 ) + g
•This method:
Assumes that dividends will grow at the constant rate “g” forever.
This method is best used in estimating equity costs for firms in stable
industries, such as public utilities.
Determination of the Cost of Equity
Capital
Ke = ( D1 / P0 ) + g
Ke = ($3(1.08) / $64.80) + 8%
Ke = 5% + 8% = 13%
Growth Phases Model
Where:
Ke = Rf + (Rm - Rf)ßj
= 4% + (11.2% - 4%)1.25
Ke = 4% + 9% = 13%
Before-Tax Cost of Debt Plus Risk
Premium
The cost of equity capital, ke, is the sum of the before-tax cost of debt
and a risk premium in expected return for common stock over debt.
Ke = Kd + Risk Premium*
ke = Kd + Risk Premium
= 10% + 3%
ke = 13%
Comparison of the
Cost of Equity Methods
– Ki = Kd ( 1 - T )
n
P0 = S
j =1
Ij + Pj
(1 + Kd)j
Assume that Basket Wonders Ltd. (BW) has $1,000 par value zero-
coupon bonds outstanding. BW bonds are currently trading at
$385.54 with 10 years to maturity. BW tax bracket is 40%.
$0 + $1,000
$385.54 =
(1 + kd)10
Determination of the Cost of Debt
(Cont.)
• Kd = 10%
• Ki = 10% ( 1 - 0.40 )
Ki = 6%
Weighted Average Cost of Capital (WACC)
•To calculate the marginal weighted cost of capital we first need to
compute financing proportions at market values for Basket
Wonders Ltd.
•Let’s suppose that BW has currently 100,000 common shares
and 10,000 straight bonds outstanding.
– MV of common stocks: 100,000 x $64.80
– MV of debt: 10,000 x $385.54
Equity
Assets - Debt =
The Sum of the Parts Approach (Cont.)
– Assets in place
Target preference: Focus on startup and early stage companies, Focus on companies that are
must build business from scratch undervalued with predictable cash
flow and operating inefficiencies
Value creation: Create shareholder value by providing high Create shareholder value by
returns to equity investors paying off lenders and servicing
debt
Exits: IPO or sale of company IPO, sale of company,
recapitalization
Investment horizon: Generally longer relative to LBOs 4-6 years
Fund examples: Kleiner Perkins (Amazon, Google), Draper KKR (Toys R Us, Dollar General),
Fisher (Skype, Hotmail) Blackstone (Orangina, Sirius)
Private Equity: Geographical Distribution
Leading Private Equity Firms by Funds Raised
• Financial buyers:
– Focus on ROE rather than ROA.
– Succeed through improved operational performance.
– Focus on targets having stable cash flow to meet debt service
requirements: Typical targets are in mature industries (e.g.,
retailing, textiles, food processing, apparel, and soft drinks)
Tax
Shield
5The equity value when the firm is sold divided by the initial equity contribution. The IRR represents a more accurate financial return, because it
(1). Raise the cash required for the buyout and design a new
management incentive system.
(5). The investor group may take the company public again if the
company emerges stronger and the goals of the group are achieved
Reverse LBOs
Requirements for Successful LBO
$300
$302
$250
$255
$200
$173
$150 $160
$50 $68
$55 $50
$32 $33
$7 $20
$0 $14
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
(€ billions)
140 300
120 250
100
200
80
150
60
100
40
20 50
0 0
1999 2000 2001 2002 2003 2004 2005 2006
Total LBO loan volume (left-hand scale)
Number of transactions (right-hand scale)
Buyouts have outperformed the S&P 500 over the past 20 years
181
Valuing LBOs
Equity Shares
Value of value of the target
Assets of the Financial Debt (H)
target leverage
Debt
+
– Equity financing, ie capitalisation by private equity funds
Valuing LBOs: Adjusted Present Value
Method (APV)
• Separates value of the firm into:
• Project annual free cash flows to equity investors and interest tax
savings for the period during which the firm’s capital structure is
changing.
– Interest tax savings = INT x T, where INT and T are the firm’s
annual interest expense on new debt and the marginal tax rate,
respectively.
– During the terminal period, the cash flows are expected to grow
at a constant rate and the capital structure is expected to remain
unchanged.
APV Method: Step 2
– Apply the unlevered cost of equity for the period during which the
capital structure is changing.
– Apply the WACC for the terminal period using the proportions of
debt and equity that make up the firm’s capital structure in the
final year of the period during which the structure is changing.
APV Method: Step 3
• Estimate the present value of the firm’s annual interest tax savings.
– Add the present value of the firm without debt and the PV of tax
savings.
APV Method: Step 5
• Recalculate each successive period’s ß with the D/E ratio for that
period, and using that period’s ß, recalculate the firm’s cost of equity
for that period.
Cost of Capital Method: Step 5
• Advantages:
– Adjusts the discount rate to reflect diminishing risk as the debt-
to-total capital ratio declines
– Takes into account that the deal may make sense for common
equity investors but not for lenders or preferred shareholders
• Disadvantage: Calculations more burdensome than
Adjusted Present Value Method
Things to Remember…
• LBOs make the most sense for firms having stable cash flows, significant
amounts of tangible assets, and strong management teams.
• Tax savings from interest expense and depreciation enable LBO investors
to offer targets substantial premiums over current market value.
• Excessive leverage and the resultant higher level of fixed expenses makes
LBOs vulnerable to business cycle fluctuations.
• For an LBO to make sense, the PV of cash flows to equity holders must
equal or exceed the value of the initial equity investment in the transaction.
Case Study: